Making Money on Bonds with Low Interest Rates | Investors Edge

By John Stewart, chief investment officer at Farmers Trust Co.

Week in Review:  Stocks Pop, Then Drop to Start New Year

As I expected, the Santa Claus rally in stocks came right on schedule during the last two weeks of December and into the first two trading days of 2022.

Then, on Wednesday, the S&P 500 dropped roughly 2% while the tech-heavy Nasdaq index was down more than 3%.

I’ve been warning for the past couple of months that a reduction in the Federal Reserve’s asset purchase program would begin to cause higher levels of volatility in the market, and this is likely the beginning of a rockier stretch for stocks. Now, don’t misinterpret that to mean the world is coming to an end and you should rush out to sell all your equity holdings.

It does mean, however, that if you have been pressing your luck on risk, it could be time to rebalance your portfolio a bit. It also means that you will have to be more discriminating in the types of sectors and stocks that you have exposure too. Many individual stocks finished Wednesday with gains despite the overall market being down between 2% and 3%.

Featured Insight:  Making Money on Bonds with Low Interest Rates

Many investors have been increasingly shunning the bond market because of persistently low interest rates.

Why own a 10-year Treasury that yields less than 2%? You’re not even keeping up with inflation.

While holding that bond for 10 years is certain to produce a small rate of return, you can in fact make substantial capital gains while holding longer-term bonds for shorter time frames. For example, if the 10-year Treasury rate were to drop from its current 1.7% down to 1.0% in the next six months, you could sell your bond for roughly 7% more than you paid for it.

Buying a 30-year bond could produce a return nearly 3 times that big for a similar move lower in interest rates.

Make no mistake, however, the reverse is also true if rates rise substantially. Trading bonds in this fashion can be risky and should only be done with the consultation of an investment professional.

Looking Ahead:  Inflation Likely to Moderate

Now that everyone is aware of the accelerating inflationary pressures we’ve all been feeling, guess what? They’re actually likely to start cooling off a bit.

Keep in mind, however; a falling rate of inflation is still inflation. It just means that prices are going up at a slower pace.

This does have implications for the performance of various asset classes. Commodities, which were one of the hottest trades of 2021, are likely to experience some downside risks in coming months. It may also mean that the longer-term bonds I just talked about will become a more attractive investment option. In addition, utilities and consumer staples stocks will likely perform well even if the overall market struggles for a while.

The December Consumer Price Index, or CPI, will be reported this coming week, and it will likely show a rate of inflation somewhat lower than November’s blazing hot 6.8% reading. 

Copyright 2022 The Business Journal, Youngstown, Ohio.